Property and equities compete on an uneven playing field

Despite the big losses suffered across some property markets around the world, many investors still believe property is one of the best investments a person can make, as it is one of the few assets that provides the opportunity for large wealth accumulation with relatively little risk.

If there was an exchange such as the ASX, where you could see the market value of your investment property every second of the day and trade it as easily as a stock, it would probably be more popular than Facebook. Yet being able to constantly see how market values were changing would probably undermine Australians’ love affair with property and the market.

Analysis of the most popular house price indices shows that returns to residential property are quite small over the long run (see chart). Despite this evidence, many investors are willing to accept negative net yields on their investment properties for a relatively low return, which is far from guaranteed. One of the reasons this may be so is leverage. Property assets are among the easiest to borrow against, allowing a buyer to put down very little of his or her own equity to buy a house and potentially leverage that average real return into something much larger.

But if the key to large profits on property is leverage, why can’t one use a similar strategy to leverage up an asset with higher real returns than property and make even larger profits?

The standard answer to this is that property doesn’t go up and down in value as often as other assets – government bonds, for example. For this reason, they must therefore be safer assets capable of larger debt financing. But is this true? Is a house that has been bought and rented out for an amount below its interest service costs really a better asset than a bond yielding 4 per cent, issued by a AAA-rated government, or shares in a high-quality company with a decades-long record of paying a steady dividend?

Although there are obvious differences between residential property and other asset classes (relatively large transaction costs and the influence of owner-occupiers on the market, to mention two), a critical difference is that many other assets are traded on exchanges where prices are quoted continuously.

When prices rally or come crashing down, human emotions can’t help influencing decisions, sending quotes whip-sawing in a manic fashion away from their true value. If there were equivalent exchange quoted prices for investment properties, I have no doubt the same dynamics would exist; when quoted prices fell dramatically and investors saw their paper wealth disappear, many would not be able to resist the urge to sell, driving prices down further in a vicious cycle that is a characteristic of other quoted assets.

Perhaps more importantly, even if the investor had the stomach to live through such price declines, a continuously quoted market would introduce the equivalent of margin calls.

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When one buys stocks or bonds on margin, it is no different to buying a house with, say, a 10 per cent down payment. Generally, when a person puts down a 10 per cent margin, his or her stocks will be sold by the ­broker when prices fall by more than 10 per cent. Imagine if your bank sold your investment property when the quoted price fell by more than your down payment, even temporarily. If this price decline was just a blip and prices returned to their original value a short time later, you would be left nursing realised losses on what was essentially a good investment, a situation any buyer of stocks on margin has experienced.

Of course, it is unlikely we will ever get an ASX or Dow Jones equivalent for houses, so perhaps canny investors should take advantage of the anomalies in the market for houses, such as easy leverage and the opportunities to uncover value the market has missed.

There may be more opportunities to get this right in the housing market, but it is also easier to get it spectacularly wrong. That’s how Ponzi schemes happen.

Economist Hyman Minsky’s description of a Ponzi scheme was an investment reliant on capital gain (or additional capital) to service interest on debt payments, which I find to be a good gauge for when a market has got ahead of itself.